The point is not that inflation is going to steam ahead but that there is any at all, given the complacency of bond and inflation markets. For this reason we are reasonably confident that inflation expectations are underpriced. This may be due to a strange relationship that has developed between the price of oil and the market’s expectations for inflation.
Though oil is only a part of the basket of goods tracked by inflation statistics, it has come to dominate inflation expectations. Consequently, inflation expectations, even those looking out 30 or 40 years, have been moving up or down in line with changes in the price of oil.
This strange relationship reached such an extreme in February that Fed officials highlighted it in a piece of research: “According to our calculations, oil prices would need to fall to $0 a barrel by mid-2019 to validate current inflation expectations.”
Sudden shift
A surprise change in inflation expectations could impair bond and other interest-rate sensitive assets quite dramatically. One solution is to own index-linked bonds, whose values are influenced not just by interest rates but also by inflation expectations. The problem is that the two can offset each other: the inflation-linked component could be gaining in value while the interest rate component might be losing value.
For this reason we have chosen to replace our index-linked government bonds in favour of a direct investment in US inflation expectations. This investment is a more effective insurance mechanism: it will grow in value if inflation expectations rise, and shrink if they fall.
